Assessing Fiscal Sustainability Subject to Policy Changes: a Markov Switching Cointegration Approach

Abstract

We propose a Markov switching cointegration approach to assess long run fi?scal sustainability. This method allows us to simultaneously: 1) test for cointegration in the presence of signifi?cant ?fiscal policy changes; 2) assess the type of fi?scal regime (whether strongly/weakly sustainable or unsustainable) that a country experienced at a given period and 3) analyse the timing of the transition between the estimated regime types. Given its flexibility, our approach enables us to uncover a richer and more complex dynamics in the analysis of fi?scal sustainability, which standard linear cointegration methods fail to capture.